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Why risk to reward ratio is important

Why risk to reward ratio is important

 
 
Back in the good old' days, people use the barter system for trading. A person
could exchange apples with oranges. The risk factor was minimum,
and most people were satisfied. Now, it's a whole different story.
 

 

With the advent of online trading, transactions happen in a few seconds. This triggers a gambling instinct in some traders, and they take Forex trading as gambling rather than a business. This can increase traders' risk levels, and they can see their dollars, saying goodbye to them. In this guide, we are going to tell you why the risk to reward ratio is important and how you can master the art of profitable trading with the minimum loss.

 

What is the risk to reward ratio?

Let's start with the basics first; what is the risk to reward ratio? The ratio of risk to reward is one of the most important aspects of managing your money in the Forex market. Many traders fail to understand how to take full advantage of the power of risk to reward. Every trader in the market wants to increase his/her profits and minimize risks. It is the basic building block of becoming a profitable trader. However, many traders do not take full advantage of the power of risk-reward ratios because they lack the patience to execute a long enough series of trades consistently to understand what the risk-reward ratio can actually do. Risk-reward does not merely mean calculating the risk and reward for trade; it means understanding that by taking two or three risks or more in all of your winning trades, you will make money in a series of trades, even if you lose most of them. When we combine sequential risk/reward execution of 1: 2 or more together with high probability strategies such as price action, we have a profitable trading recipe.


Understanding the concept of risk to reward ratio

If you are a beginner, then you may have the experience of making some profit. However, all it takes is one bad trade, and all your profits start vanishing. This is when the importance of the risk/reward ratio comes into play. The key to success is to find the right balance between the risk per trade and the desired profit you are striving for. Besides, this balance should be realistic and consistent with your trading strategy. The risk-to-reward ratio measures your potential return for a given amount of risk. If your risk/reward ratio is 1: 3, you risk 1 dollar to earn 3 dollars.

To help you understand better, here's an example:
If a person, whom you hardly know asks you to lend $100 and offers to pay $101 in two weeks. This might not attract you. But what if he offers $200? The risk of losing $100 to gain $100 might be appealing for some of you. In this scenario, the risk/reward ratio is 2:1, as it allows you to double your amount. Similarly, if a person offers $300, the risk/reward ratio is 3:1. Generally, many experts trade at a ratio of 2:1.

Now that you have understood the concept of risk to reward ratio, it is time to dive into how you can calculate your trading risk to rewards.


How to calculate the risk/reward ratio?

To calculate your risk/reward ratio, you divide your net profits (rewards) by your maximum risk amount. If you risk 50 points in a transaction and set a goal of making a 100 points profit, your risk/reward ratio is 1: 2. In Forex, before calculating the risk/reward ratio, you need to consider the spread charged by your broker. Often, traders complain, they have calculated the risk/reward ratio, but they are not getting according to their calculations. This is because of the spread. If your calculated risk/reward ratio is 1:2, you will get an approximate 1:1.14 because of the spread.


Why do you need to set stop-loss with the risk/reward ratio?

An experienced trader will never let go of all his invested funds. For getting maximum from your risk/reward ratio, you need to set a stop-loss. If you risk 20 pips of EUR/JPY to get 200 pips, the risk/reward ratio will be better at 100 pips. In other words, the tighter the stop-loss, the better risk/reward. Of course, this will limit your profits, but it will limit your risks also. Every professional trader knows that trading with conservative risks is better than taking an aggressive reward. You need to calculate your risk/reward ratio realistically and conservatively.

 

Position sizing and risk to reward ratio


Position sizing is the process of adjusting the number of lots you will trade in a trade to meet a predetermined risk size and stop-loss distance. Position sizing is one of the best strategies for risk management. To manage risks with position sizing, you need to follow three steps:

1. Firstly, you need to determine what amount you are willing to lose, as when trading high profitable trades come high risks.
2. Secondly, finding the position for placing a stop-loss. The position sizing demands stop-losses to be placed at the recent low for buy positions and the current high for sell positions.
3. Thirdly, you need to calculate the number of lots or mini-lots that will give you the required amount of risk at a distance from a stop-loss. One mini-lot is usually $ 1 per pip, so if you have a risk size of $ 100 and your stop loss distance is 50 pips, you can trade two mini-lots; $ 2 per point X 50 pips stop loss = $ 100 risk.


Key takeaways

Now that you know about the risk to reward ratio and its importance, here are a few things you can do to make your trading more profitable:
• Learn about risks in Forex.
• Use a stop-loss.
• Don't risk more than you can afford.
• Limit yourself from using leverage.
• Don't expect too much too soon.
• Use take-profits to protect your profitable trades.
• Control your emotions.
• Go with the trading plan.
• Diversify your investments.


We hope this article provided you with the importance of risk to reward ratio and how you can become a profitable trader by managing your losses.

HIGH RISK WARNING: Foreign exchange trading carries a high level of risk that may not be suitable for all investors. Leverage creates additional risk and loss exposure. Before you decide to trade foreign exchange, carefully consider your investment objectives, experience level, and risk tolerance. You could lose some or all of your initial investment; do not invest money that you cannot afford to lose. Educate yourself on the risks associated with foreign exchange trading, and seek advice from an independent financial or tax advisor if you have any questions. Any data and information is provided 'as is' solely for informational purposes, and is not intended for trading purposes or advice.